First-Preferred Stock

  

Categories: Stocks, Investing

You’re waiting to board an airplane. You hear “Sapphire group now boarding.” Then “mega-Platinum shiny-things group, now boarding,” yada yada yada.

A first-preferred stock is like these boarding groups: it’s one of many groups of stocks, with each group getting treated a certain way and costing a certain amount.

First-preferred stockholders don’t have voting rights, but they are in a group above second-preferred stock and common stock when it comes to dividends and assets.

That means that, when times are good, first-preferred stockholders will be getting the extra dividends before others. When times are bad, first-preferred stockholders will be getting payouts before common stockholders (and second-preferred stockholders).

First-preferred stock is like being in business class...or wait, maybe the gold, ruby, professional business class.

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Finance: What's the Difference Between C...54 Views

00:00

finance a la shmoop. what's the difference between common and preferred

00:05

shares? hmm well common versus preferred shares. the Smackdown. who would win well

00:12

in a fight near bankruptcy a financially stressed situation preferred shares win

00:18

hands-down. in the investing landscape there's a stack or priority list for who

00:24

gets paid what when. in the situation where a company is insolvent or [kid smiles and gives thumbs up]

00:29

basically goes bankrupt. that is you know nots on this storm and warm long .well in

00:35

the real world there's preferred common stock in both private companies and

00:39

sometimes in public ones . when private companies preferred is the dominant

00:44

initial investing vehicle. in public companies it's the opposite . why? well

00:49

because little tiny companies with two geeky techie kids in a garage in Palo

00:54

Alto are vastly more risky investment than those done in large public

00:59

companies like in coca-cola or Pepsi. when you buy shares of Apple today

01:04

you're buying common shares. ticker a APL this thing right here .so the priority

01:10

stack of who gets what when goes something like this- any cash left over

01:14

in a company liquidation meaning bankrupt so the auctioneers are just

01:18

selling it on eBay in parts. the first money goes to employees like we wrote a [cash in water]

01:23

paycheck. and then there's vendors and like a plumber an electrician who came

01:27

did work and never got paid for it. and then there's bank debt if there is any

01:32

collective paid next. then secondary loans from more risky than bank lenders

01:38

get paid like if venture debt is out there it's it's below bank debt. then

01:42

preferred shares get paid off in full then finally common shareholders get

01:47

paid if there's any money left over and there usually isn't. now in the hopes

01:51

dreams and whimsy of early-stage company investors called venture capitalists, all

01:56

of their companies do well grow fast and they go public. and usually at the IPO

02:01

all of the shares have preferred convert into one class of share called

02:07

common stock. and that's when things go well . that's what venture capitalist

02:12

dream about everything converts preferred becomes common, one class of [man looks excited as he holds pile of cash]

02:16

stock like a APL .but when things don't go so well it gets ugly.

02:20

well uglier. yeah alright let's walk through an example. big deal.com rates

02:25

four million bucks in venture capital. took out a 1 million dollar bank line of

02:30

credit which it fully drew down meaning actually borrowed a million dollars so

02:34

it's got five million bucks cash to working with and it has 200 grand in

02:38

builds owed to employees and vendors like Amazon Web Services Paddy's party

02:43

planning and Joe's five-second rule catering. the company is then sold as

02:49

scrap to a competitor for seven million dollars. so who gets what? well first the

02:55

employees and vendors get paid two hundred grand right off the top three

02:59

six point eight million left. then the million bucks from the bank credit line

03:03

gets paid. and if there was any BAC interest owed well that'd be in here as

03:07

well so we're down to five point eight million dollars left. then the four

03:12

million dollars of venture capital investment gets paid because it was in [equation]

03:16

preferred shares. that gets paid back to the venture guys who notably get all of

03:20

their money back even though the company did not do well. yeah so you'd ask why do

03:24

venture capital people get such a perk of getting their investment back first

03:28

the head of the common shareholders and the founders of the company? well because the

03:32

venture guys take a lot of risk and because many many many companies can't

03:36

even sell for the seven million dollars in scrap, so the four million that the

03:40

venture capital is put in often is worth well pretty much zero zilch zip. so the

03:45

investors have to be paid for the risk that they're taking when they invest

03:50

otherwise they just wouldn't invest as much and that's bad for everyone. after [investors smile]

03:54

this four million bucks is gone well they're swimming at one point eight

03:57

million dollars left and it's that amount that gets split among all the

04:01

other common shareholders. the founder owns 30% of the common at this point. so

04:07

she keeps five hundred forty grand. and the employees who had stock options and

04:11

other investors while they keep the rest. all kind of split up. in practice the

04:16

details make these transactions way way way more complex and there's lawyer

04:19

involved. sorry some term sheets from venture capitalists required that their

04:24

preferred be paid back twice before any common gets paid. so in this case the

04:29

four million dollars would have had to be eight million dollars paid back to

04:33

the venture guys before anything went to the common shareholders. there we've got [list of who gets paid what]

04:37

nothing right why would a founder take such abuse and what's called a 2x

04:42

liquidation preference? well the answer valuation. that is for a simple 1x or one

04:49

x just give us our money back and we'll move on kind of deal the valuation of

04:55

big deal com might be ten million dollars. but if the founder wants a

04:58

valuation of fifteen million dollars or more to stave off dilution from outside

05:03

investors. well she might give on key terms like liquidation preference

05:08

multiples because before the company's funded she's dreaming she's the next

05:11

Google right? and in the case of big deal commit mattered a lot. here the founder

05:16

leaves with over half a million dollars not bad for a failed company right? but

05:22

if they've negotiated for a higher valuation and the VCS had gotten a 2x [woman walks off with pile of cash]

05:26

liquidation preference well the founder would have left with nothing. the idea

05:32

here is that term sheets are complicated and there's an army of lawyers in

05:36

Silicon Valley who negotiate these things all day long. this all they do. so

05:41

I don't want to negotiate against them. got it ?there you go

05:44

common versus preferred shares. not a fair fight. check they're not even in the

05:49

same weight class. yeah all right moving on [cage fighter jumps up and down]

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